The European Central Bank, followed by the US Federal Reserve and then the Bank of China, have all confirmed that a new era of falling interest rates has arrived. Historically, small cap equity markets have consistently outperformed during times of monetary easing and these latest central bank moves suggest the period of small cap underperformance may be coming to an end.
“There is a tide in the affairs of men, which, taken at the flood, leads on to fortune….”
Read literally, the words of Brutus in Shakespeare’s Julius Caesar, were urging Cassius to march on Philippi to meet Octavius and Antony in the struggle for Roman power. But as is so often the way with Shakespeare, his writings can be interpreted to mean many things and they are often unconstrained by the passage of time.
Dollar Bill likes to read Shakespeare with a good cigar and despite the relative haze in the smoke-filled receiving lounge, it is clear that The Bard’s words were all about taking opportunity when it presents and furthermore, when “taken at the flood”, brave action can lead to fortune.
While small cap equity markets were likely not on Shakespeare’s mind, his words may still give heart to those lamenting the stubborn mule that has been the small cap market for the last little while … particularly those who can sniff an opportunity and instinctively predict the flood because right now, there are some compelling signals suggesting the tide may be about to turn for small caps.
For more than half a century, falling interest rates have happily coincided with small cap outperformance. In the past five years in particular, global rates whiplashed to zero during the COVID pandemic, then back to 20-year highs in response to the resulting inflation.
Now, the world’s biggest central banks have started cutting again and when it comes to small cap investments, this opportunity – potentially at the top of the rate cycle – suggests rewards for the brave may be just around the corner.
Recent data provided by US-based Calamos Investments illustrates, quite obviously, the outperformance of small caps during past cycles of easing interest rates going back 50 years.
Over half a century, small caps have consistently outperformed both mid cap and large caps when interest rates start to fall and now, forward yield curves in every major market – with the exception of Japan - tell the same story, which is that rates are heading south.
The implication, therefore – and nothing is certain of course – is that the tide just might be about to turn for small caps.
One of the great dichotomies in the recent performance of global equity markets is that of the major indices when marked against that of small caps.
The US, European and local market indices are flying high. In the United States, tech stocks – most notably those at the heartbeat of AI development – have been leading the charge, with Nvidia, Oracle, Microsoft, Amazon, Meta and the like now boasting trillion-dollar valuations and all commanding a major weighting in stock indices. Combined, these leviathans have been powering the US stock market to new highs on a regular basis.
The Australian bourse’s uptrend to regular new highs has also been dominated by our own local market heavyweights, notably the big four banks, Newmont and another of the “Big 7” listings, Goodman Group.
The share prices of the big four local banks are up between 20 and 50 per cent for the year (led by Westpac – up 50 per cent in 12 months). Newmont has scaled more than 30 per cent higher, while quite incredibly, Goodman Group has returned a capital gain of more than 60 per cent in the past 12 months.
For a company with a $60 billion market cap, this is an extraordinary performance.
Given their collective weighting in the local indices, it is little wonder the All Ords and ASX-200 are soaring skywards.
For small and micro caps, however, it has been a very different story. But for how long?
Large cap stocks, which generate their own revenue, are generally not subject to the whims of equity market capital raisings. Small caps, however, many of them without the luxury of earnings, are existentially reliant on capital markets to fund ongoing operations. Significantly, for at least the past 18 months, capital has been hard to come by for small caps, which has led to decreased market activities and lacklustre share price performances.
For the past few years, most Western economies have been struggling to tame inflation. Pent-up consumer demand following the COVID pandemic and associated supply chain disruptions alongside huge amounts of Government stimulus, combined to underpin a sharp spike in global inflation.
The world’s central banks, having cut rates to nothing in an attempt to keep things ticking over during the pandemic, responded to the subsequent inflationary surge by flicking the switch on a sudden about-face, and jacking up interest rates from next to nothing to 20-year highs at a rapid clip.
Consequentially, capital, for those who rely on it, quickly dried up, fund flows to higher risk investments evaporated and small caps bore the brunt, with significant sector underperformance the result.
The US small-cap “Russell 2000” Index, which now sits at about a 30 per cent discount to the large-cap S&P 500 Index as measured by trailing price/earnings ratio, provides a telling disparity between small and large cap listed companies. Compared to the historical average of about 4 per cent, this is an extreme underperformance.
The discount also presents in spite of the superior earnings growth of small caps running at almost 10 per cent annualised from 2011 to 2024, compared to 7.5 per cent for large caps. With more than 25 years of investment experience under his belt, Dollar Bill can’t remember a time when such a dislocation of value has ever been sustained for any length of time.
Analysts often label these extreme peaks and troughs as market distortions that inevitably correct themselves. And while, despite some opinions, Dollar Bill doesn’t have a crystal ball, the law of averages is well within his wheelhouse, which begs an immediate question: “If everything does eventually return to the mean, then the tide for small caps should be, at some point soon, about to turn – particularly if interest rates are about to head south.”
In the past couple of weeks The US Federal Reserve cut rates by a more-than-expected 50 basis points. It was the first cut of the new cycle, with the previous one having seen rates and yields soar from virtually zero. Now, US yield curves have priced in a series of further, aggressive rate cuts stretching well into next year and pointing to the dawn of a new, far more permissive era when it comes to the cost of capital.
The European Central Bank also recently confirmed its second rate cut in the new cycle and word on the street – and current futures market pricing – strongly suggests local rates will shortly follow the global trend south.
Then, to complete the trifecta of major global government stimulus measures, The People’s Bank of China has announced a medium-term rate cut of 50bps on top of an 800 billion yuan (US$114 billion) capital injection into the Chinese stock market. The BoC also announced plans to relax capital requirements on banks – known as the Reserve Requirement Ratio – meaning banks won’t have to hold the same level of cash reserves as before, potentially freeing up an additional 1 trillion yuan (US$142 billion) in funds for greater investment.
As an interesting aside, all of these combined – if not coordinated – moves came on the eve of London Metals Exchange week where producers, purchasers and traders meet to agree on contract pricing for the year ahead. The stimulus measures announced by the US Fed, the ECB and BoC saw copper prices surge back above the critical US$10,000 per tonne mark.
The new trend of easing interest rates does seem to be set in stone, with the cost of funds heading south, which historically has fed appetite for investment risk. The pipeline of funds flowing into small cap equity investments could (should?), be about to open.
Dollar Bill was hunting around for some additional factual support for these suppositions and just happened to stumble across analysis provided by that up-and-coming mob, JP Morgan. According to the boffins at JP Morgan, the outperformance of the big board has been ridiculously top-heavy.
Nvidia, Microsoft, Alphabet and Amazon contributed to more than half the gains registered on the S&P in the first six months of the year. To quote JP Morgan’s investment strategy paper, when it comes to small caps, “the tables have now turned”.
Furthermore, analysts there also point to record shorting of small caps up until recently, positions which are now being significantly wound back, spurred by falling interest rates, both actual and expected. The unwinding of short positions should also contribute to a snap back.
History and unfolding events are all combining on the side of small caps.
There is however a clear risk to this scenario of ongoing rate cuts, which has only just reared its ugly head. Dollar Bill was stirred from slumber on his favourite chaise lounge just the other night to see reports on Bloomberg of missiles flying across borders in the Middle East.
It certainly looked ugly and any further deterioration of events in the region could clearly impact on global oil prices, fuel inflation and possibly put on hold any short-term plans for further rate cuts – although Dollar Bill just might stash a bit of gold in the pillowcase as that always works well in times of war.
However, casting an eye to history again and previous geopolitical upheavals, Dollar Bill believes any potential spike in oil prices will be short-lived and any impact transitory … fingers crossed.
Optimism aside, the groundswell of evidence suggests that when it comes to small cap investing, the sun may be about to rise again. And you don’t have to be that brave to back what would merely be 50 years of history repeating itself when it comes to the correlation of falling rates and small cap outperformance.
Just add a sprinkle of timing and luck – the latter of which Dollar Bill is quite experienced in – and the tide could well be turning in the affairs of small caps. Returning to paraphrase the words of Brutus, this opportunity, if taken at the flood, could indeed lead on to fortune.
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Dollar Bill (sometimes known as Bill McConnell) is an associate director at Bulls N’ Bears and a former derivatives trader. He is also a former financial journalist and a raconteur of note. This column is for informational and entertainment purposes only and nothing contained within it constitutes financial advice – in fact Dollar Bill specifically recommends that you seek advice from someone other than him!
